SaaS Valuations Deserve Their Place In The Clouds

One question we are hearing a lot at the moment is whether the party in the Communications, Media and Technology (CMT) sector is beginning to wind down. It’s hardly an unwarranted concern. Amid fears over global economic slowdown, stock market volatility early in the year, a dearth of IPOs and the immediate-term prospect of Brexit in the European market, it’s natural to expect the sector at the heart of 2015’s unprecedented levels of global M&A activity to run into a few headwinds.

Ultimately our answer is a little more nuanced than a definite “yes” or “no”. But certainly both public and private technology markets have undergone fundamental change recently. The unforgiving treatment doled out to a number of newly-listed and high-profile pre-profit tech companies on the capital markets late last year dampened interest in Wall Street IPOs to post-2008 record lows in early 2016. And if 2015 was the year of the unicorn (the private technology business, also typically loss-making, with a $1bn+ valuation), then 2016 is feeling distinctly less mythical for venture capitalists and the start-ups clamouring for their backing.

Naturally it is the most innovative, cutting-edge and – plainly speaking – fashionable subsets of the CMT sector – those to which technology-hungry investors had been flocking in ever-increasing numbers – that have borne the brunt of this market correction. SaaS (Software as a Service) is one such example.

For the uninitiated, SaaS companies are essentially distinguished from conventional software companies by the way in which they license their proprietary software. Rather than selling the software “as a product” to be installed on personal computers, they host it centrally and allow their end users to access it through web browsers and on an on-demand basis in return for subscription or license fees. San Francisco-based Salesforce stands as perhaps the best-known example of a SaaS exponent.

What may seem on first glance to be a relatively vanilla change in delivery method actually plays into the broader and much more exciting trend of the shift to cloud computing. Moreover, the SaaS licensing model allows for far greater flexibility in implementing software updates and ensuring inter-user compatibility. For these reasons, it represents a major transformation in how individuals and companies use software on a day-to-day basis.

Investors in capital markets certainly responded to SaaS propositions as such. Arma Partners’ analysis of Capital IQ data for a sample of 37 public (and predominantly US-listed) SaaS companies shows that, between March and November 2015, their shares traded at an average multiple of 6.24 times their projected revenues for the next 12 months. This represented a more than 50% premium on the corresponding figure for a parallel sample of 47 established and conventional listed software companies. Central to these disproportionately high levels of investor interest were the recurring (hence predictable) nature of these SaaS companies’ revenues and the belief that, upon reaching critical mass and profitability, they would enjoy the higher margins associated with a SaaS business model.

However, the actual profitability of these companies was a comparatively immaterial concern. The same two data sets show that our 37 SaaS companies had an average projected earnings-to-revenue margin in the next 12 months of 13.2%; our 47 conventional software companies had a corresponding figure of more than twice that, at 29.8%. In fact, almost half of the SaaS companies were loss-making, and seven were forecast to repeat losses in 2016 as well. This compares with zero on both counts for the established software players. And yet it was those very same SaaS companies that were granted the significantly higher valuations, relatively speaking. At this time, as far as software was concerned, potential had a premium on profit.

Whilst such an approach inevitably elicits the contempt of bearish commentators alert to the risk of the next tech bubble, it is in certain respects defensible. A point I have touched upon before in this column, and will invariably return to again, is that technology has fundamentally transformed every other industry and aspect of everyday life. Consequently, the dotcom-era constraints that previously existed on demand capacity have largely been swept away. Bearing this in mind, high cash burn by young companies in return for scale in vast, untapped and ultimately (if not always immediately) lucrative markets might reasonably strike investors as a worthwhile trade-off.

Nevertheless, company valuations do need to remain rooted in conventional indices of worth, such as earnings and cash flow conversion. The tremors that shook global markets early this year were the occasion for these more quantitatively-based measures of value to return to the fore. Accordingly, our 37 SaaS companies experienced a 27% fall in average enterprise-value-to-next-12-month-revenue multiples for the period between December 2015 and March 2016. Meanwhile, our 47 established software companies sustained a corresponding hit of only 5%, consistent with the wider decline across the relevant markets.

But the recent sea change in how SaaS companies are being viewed and valued is illustrative of other broader and more encouraging trends in the CMT sector, beyond a market correction pegging back overvalued businesses. In particular, the way in which profitable and cash-flow-generating SaaS companies have ridden out the market turbulence to emerge as more esteemed businesses that combine cutting-edge technology with commercial viability speaks to the wealth of compelling investment opportunities that remain throughout the CMT sector in 2016.

For example, a closer analysis of our 37 sample SaaS companies shows that those with revenue growth above the group median fared worse in the early 2016 market correction than those whose revenues were increasing more steadily. And, conversely, those SaaS companies with above-median EBITDA margins and free-cash-flow-conversion rates went from trading at lower revenue multiples to their below-median counterparts from March to November 2015, to trading at higher multiples from December 2015 to March 2016. Put simply, among SaaS companies as well as across the entire CMT sector, an earlier emphasis on rapid growth has given way to investors valuing profitability and cash flow more highly.

Away from public markets, the evidence necessarily becomes a little more anecdotal. But what has been particularly conspicuous is how private equity-backed investment in SaaS companies has continued apace. Nor is this just the case in Europe, where SaaS companies already tended to rely more heavily on private M&A activity in the absence of any public markets as attractive as the NASDAQ or NYSE, and where the conditions for financing the debt portions of leveraged buyouts have remained more amenable.

In the US, private equity buyers in early 2016 faced a volatile leveraged finance market that required several high-profile renegotiations of prices agreed in the more hospitable climate of 2015. Yet North American SaaS companies including IntegriChain, Solera Holdings and Keal Technology were all still snapped up by private equity firms or their portfolio companies. This, again, speaks to the continued attractiveness of many SaaS prospects, with their subscription-based business models generating the recurring revenues required to service even high levels of leverage.

So has the CMT party come to an end? Judging by the SaaS example, no, it’s still continuing – albeit with the music volume turned down a touch, and a door policy that’s just a little stricter than before.

This article was written by Paul-Noël Guély from Forbes and was legally licensed through the NewsCred publisher network.

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